Does Yahoo Prove Buybacks Aren't As Good As Buffett Thinks?

| About: Yahoo! Inc. (YHOO)

Summary

Yahoo has spent billions buying back stock.

With the shares falling and the business in disarray that looks like a bad use of investors' money.

But does that mean buybacks are bad?

Image Source Yahoo!

Warren Buffett of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) fame has laid out pretty good logic for liking buybacks. But then you see a situation like Yahoo (NASDAQ:YHOO), where a company in disarray appears to be using buybacks to prop up earnings when it doesn't seem to have good growth options, and the buyback naysayers may have a point, too. The answer here isn't yes or no when it comes to buybacks, it's maybe.

Why Buffett likes buybacks
Buffett's fondness for buybacks relies on a bit of big-picture wisdom. Essentially, every share that a company buys back increases the ownership interest of the remaining shareholders. For example, in 2012, a year in which Buffett wrote extensively about buybacks, Berkshire's stake in American Express (NYSE:AXP) increased from 13% to 13.7% because of buybacks. While 70 basis points may not sound like much, it's a 5% jump in the size of Berkshire's ownership.

Essentially this dynamic means that every dollar a company reinvests in itself (in the business, not in buybacks) works that much harder for its remaining shareholders. True, buybacks also mean higher earnings per share in the near term, but the long-term implication is what Buffett is focused on. That compounding of investor capital leads to good things over the long-term if it increases the value of the company's business.

Here's the wrinkle: Buffett explains that "price is all important" when looking at repurchase decisions. Buy too high and there were probably better uses of that shareholder capital. Buy low, however, and shareholders will benefit. It's why he's particular when it comes to Berkshire buying its own stock, most of the time he doesn't think the price is low enough to benefit shareholders like himself.

Yahoo and that sinking feeling
Buyback naysayers, meanwhile, will argue that using investor capital to buy back shares is a tacit admission that a management team can't find better uses for the cash. Or, worse, an attempt by management to artificially prop up earnings when results would otherwise be weak because of stagnant or falling revenues.

YHOO Chart

YHOO data by YCharts

Yahoo is currently providing plenty of fodder for these arguments. The struggling Internet company started to buy back shares aggressively in 2010, with the stock only starting to heat up in 2012 or so. They peaked in late 2014 and have since seen a pretty dismal decline. That price chart recap overlooks some notable company-specific events, however, like continuing to lose ground to search engine competitors and a number of failed growth initiatives. Then there's the not so small issue of a valuable stake in another company that's helped prop the shares up, though it had nothing to do with Yahoo's main business. All of which has brought Yahoo to its current predicament: the one-time Internet titan looks like it will be sold off to the highest bidder, cut up or in one piece.

Clearly, those stock buybacks didn't work out as investors might have liked at Yahoo It's pretty obvious that owning a greater percentage of a struggling company isn't likely to be good for investors. But based on Yahoo's track record, letting management invest it in new growth opportunities probably wouldn't have turned out much better...

Not always the case
But that math isn't exactly fair to apply to every company buying back stock. For example, Yahoo's troubles are truly fundamental in nature, it appears to be a slowly faltering company with flaws that can't easily be fixed.

Eaton Corp (NYSE:ETN), in comparison, has announced its intention to materially up its share buybacks over the next couple of years. The cyclical company is feeling the pinch of an industrial downturn, so it's shares have been relatively weak of late, along with its results. But it's still wildly profitable and there's no reason to believe that the over 100 year old company has somehow suddenly lost its way.

Eventually, the cyclical industrial industry will turn and Eaton's results will pick up again. Or at least that's my belief. So, while I'm not a huge fan of buybacks, I'm perfectly content that Eaton is buying its own shares right now at prices that I think are a decent deal. And it's not like Eaton isn't investing in its own business. The conglomerate frequently does bolt on deals, invests in research and development, and is a pretty active manager when it comes to its business portfolio.

Could Eaton's buyback plans turn out to be ill-timed? Of course. But is Eaton in the same situation as Yahoo? No, it doesn't look like it. For confirmation, Yahoo has struggled at the hands of competitors and Eaton is struggling along with the rest of the industrial sector.

I prefer dividends
To be honest, I prefer that a company with extra cash send it my way via dividends. That said, I also understand the need to ensure that dividends are stable to growing over time. Investors, myself included, simply prefer stability.

So buybacks are a good way to "return value" when a dividend hike might not make sense or be sustainable over the long haul. Eaton's dividend record, by the way, is fairly good, with a generally rising annual payment over time. (The dividend stagnated during the 2007 to 2009 recession, but has since been growing again.)

That said, it does appear that companies often buy back stock at the worst possible moments, essentially buying high and not keeping with Buffett's warning that price is a key variable. And there's clear situations in which buybacks are nothing more than an attempt to offset stock grants and, perhaps, are being used to artificially prop up earnings.

My take on the issue, then, is that there's far more gray than black or white. Stock buybacks aren't a good/bad call, they are situational. For example, IBM's (NYSE:IBM) massive stock buybacks in the face of falling revenues has left some questioning the value of its purchases. IBM would likely counter that it has plenty of cash flow to cover the buybacks and invest in its business, so it's just returning value to shareholders in a different way. So far, however, remaining stockholders haven't benefited all that much from the repurchases, since the shares remain well off their highs.

But, IBM looks like a company that's remaking itself again after a long and successful history of adjusting to technology's waxing and waning currents. If it can pull off the current transition, then longer-term shareholders should be happy with the buybacks. I'm a believer that IBM will pull off the transition it's making today, so the buybacks don't bother me. Especially since it's still generating plenty of cash flow and the new businesses on which it's focused are posting robust growth numbers. Moreover, it hasn't shirked away from investing in the business, either. If I'm correct, every share IBM buys back is good news for me.

So while The New York Times highlighting Yahoo as evidence of the "buyback mirage" looks pretty compelling, I'd argue that it's one example. True, Yahoo highlights some of the buyback problems that investors should, rightly, be concerned about. But it shouldn't be taken as a condemnation of all buybacks. Buybacks aren't good or bad, because it depends.

Disclosure: I am/we are long IBM, ETN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.